Is This Time Different? A Look at Duration
By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD)
As we have written about, historically speaking the high yield bond market has performed well during periods of rising rates, due to the fact that the high yield market tends to have a lower duration than other fixed income asset classes, has a zero to negative correlation to Treasuries, and generally rates are rising during periods of improved economic environments, which is a positive for these credits. However we were recently asked if this time is it is different because of the historically low rates. We believe that the answer is both no and yes.
Generally speaking, we believe that the factors that have helped insulate the high yield market from higher rates in the past still are valid today—the relatively low duration and the fact rates generally increase during an improving economy. Addressing the latter first, we would expect that if the Fed does eventually raise rates, it would need to be on the back of an improving economy. We would expect that in order for a sizable increase in rates we would need to see an improvement in the economy off of where we are today, and we would expect those economic conditions would benefit corporate credit.
Turing to the relatively low duration, looking at duration levels over the past nearly 15 years, we see that current duration levels are certainly not elevated by historical standards.1
Duration is a measure of interest rate sensitivity, and takes into account yield. Though there are different ways of calculating duration, it is broadly defined as the effect a 100 bps (1.0%) change in interest rates would have on the price of a bond. One would think that if the currently low yields by historical standards were to dramatically change our interest rate sensitivity going forward, that would be reflected in the duration number. But as the graph above indicates, we are not seeing an elevation of duration.
However, on the flip side, we are seeing a portion of the market that is at very tight yields, so the usual benefit that a higher starting yield the can help cushion the rate change does not hold water for this segment of the market. The following chart depicts the issue.2
The highest rated piece of the high yield market, split BBB has a duration over 1 year longer than the next two highest ratings categories (BB/Split BB). Then once you get down to B rated securities and below, you are looking at about another year decline in duration. We see this split BB to split BBB portion of the index as trading more along the lines of investment grade, which does have a positive correlation to Treasuries and has historically performed well under that of the high yield market during periods of rising rates (though still a positive performance, see our blog “High Yield in a Rising Rate Environment: A Perspective on Historical Performance”). When we talk about tight yields, this highest rate portion of the high yield index exemplifies the issue, trading at a yield to worst of 3.81% for split BBB and 4.3% for BB rated bonds, bringing down the broader index statistics.
This is why active management within the high yield market is essential. Active managers are able to avoid the quasi-investment grade names that trade at very low yields and higher durations, the credits that we would expect to be much more impacted by interest rate increases, and take advantage of credits that are at seemingly attractive levels.